Today we'll evaluate REA Group Limited (ASX:REA) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for REA Group:

0.40 = AU$456m ÷ (AU$1.6b - AU$445m) (Based on the trailing twelve months to June 2019.)

So, REA Group has an ROCE of 40%.

View our latest analysis for REA Group

Is REA Group's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, we find that REA Group's ROCE is meaningfully better than the 12% average in the Interactive Media and Services industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, REA Group's ROCE in absolute terms currently looks quite high.

We can see that , REA Group currently has an ROCE of 40% compared to its ROCE 3 years ago, which was 24%. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how REA Group's ROCE compares to its industry. Click to see more on past growth.

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for REA Group.

How REA Group's Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.